John McCain is sorta right about the SEC, but what about the hedge funds?

In 2004, the SEC adopted rule changes that allowed 5 investment banks to increase their leverage from 12:1 to 30 or 40 to 1. Details here. McCain has angrily said he would fire Chairman Chris Cox (which the President has no authority to do), but, so far as I know, Cox had nothing to do with this—he took his seat on the Commission August 2, 2005.

Why did the SEC made that imprudent rule change? My guess is that the investment banks were in direct competition with unregulated hedge funds, that the hedge funds were using leverage at 30:1 and 40:1, and that the banks begged to be allowed the same imprudent freedom. It's amazing to me that we're not hearing more about collapsing hedge funds—or indeed anything about what they are doing and having done to them by the financial crisis. Hedge funds are the core of the huge "shadow banking system."

Oh, you wanted the names of the 5 investment banks that were the exclusive beneficiaries of the SEC rule change? Bear, Lehman, Merrill, Goldman, and Morgan. Yesterday the Fed agreed Goldman and Morgan could convert to bank holding companies which, I guess, means they will have to revert to commercial bank reserve ratios. Sic transit "financial innovation."

Update on Friday, October 3, 2008 at 05:21PM by Skeptic

Today's NYT has a pretty complete story on what happened.  The 5 investment banks achieved 2 goals with one rule change.  First, they got relief from 7 years old reserve requirement on their broker/dealer subsidiaries, enabling them to move cash to the parent companies and participate in the fast-growing market for mortgage backed securities and other derivatives.  Second, they avoided regulation of their European subsidiaries by agreeing to have the parent companies regulated by the SEC. 

According to a graphic in the print edition of the NYT, only Merrill's leverage greatly increased, from about 17:1 before the rule change to about 32:1 recently.  The Goldman ratio moved from a range of 16 to 20 to a high of about 24:1.  Bear, which was already at 27 to 29, increased to high as 33:1.  Lehman, like Bear, was already high (range 22-27) and increased to 33:1 after the rule change.  Morgan Stanley, which so far has survived, also had high leverage that went higher, 22-25 before to 33:1 after.  So, apparently, leverage is not the whole story behind the varying degrees of health of these 5 banks. 

On the regulatory front, they successfully avoided regulation in Europe, and the SEC never effectively regulated, or even monitored, the parent companies.  Perhaps that's why McCain wants to hold Cox accountable.  The NYT piece says the SEC's neglect is consistent with the laissez faire philosophy of the Bush Administration that also affected what happened at CPSC, EPA, OSHA and other agencies.